Morningstar's investor return data show that investors systematically undermine their own results with poor timing. Joining me to discuss that topic is John Rekenthaler; he is vice president of Research for Morningstar. John, thank you so much for being here.

John Rekenthaler: Good day again, Christine.

Benz: John, let's talk about our investor return data. First can you give us just an overview of how we calculate those numbers?

Rekenthaler: Sure. The standard return that you see for a mutual fund is called time-weighted return, and it doesn't measure how much money is in a fund at a given time. So, if a fund is very small and has, say, terrific performance, that performance counts just as much for the calculations as if the fund is very large. So, it doesn't look at the asset base.

Investor returns, however, does look at the asset base, because investor returns are what you need to know--did people actually make money on this fund?

Let's take a simple example: you have $1,000 in an investment, and it doubles over the next year; you just made a $1,000 profit. So, then you put $8,000 more into the fund. So, there is $10,000 in your investment, it drops in value in half. You went from up a 100% one year, you went down 50% the next year.

So, according to the Morningstar calculations, and everyone's standard total return calculations, that fund broke even, but you made $1,000 in the first year, and you lost half of your assets, or $5,000, the next year, down $4,000. So, standard numbers say it's break-even, but you're out $4,000 because you had more money in when the fund performed poorly than you did when the fund performed well.

Benz: And that's a trend we see a lot.

Rekenthaler: That's a trend we see a lot, and that's the way to think of investor returns: Are people timing their purchases correctly, because if you compare investor returns to what the standard total return calculations do, investor returns should match the standard calculations if [investors'] timing is neutral. If you just sort of randomly put new money in, and turned it into darts and just threw it at the wall, investor returns should match the total returns. If you see that the investor returns are less than the total returns overall, people are systematically making mistakes. If they're better overall, then they're systematically getting it right.

Benz: So, investors can see on Morningstar.com the investor return data on a fund by fund basis. But I think it gets a little more interesting when you look at some of the categories and some of the asset classes, and we can observe some trends about what investors tend to do. And when you look at that data, John, do you see that any types of funds tend to be exceptionally poor in terms of investor returns, so their timing tends to be horrible? And on the flip side, are there any categories where you see that investors do really well.

Let's start with the losers, where investors' timing tends to be really bad.

Rekenthaler: Before jumping into the losers, it's worth mentioning that almost across the board, every type of fund over every time period you look at, there tends to be a negative investor gap for investor return, meaning investor returns are worse than the traditionally calculated fund returns, meaning systematically investors are mistiming their purchases. I'd like to tell you that often you see the reverse, and people do well, but that's a rare thing.

Second is, there is quite of bit noise in these numbers. So, the longer the time period you have and the more you're doing this among broad groups, rather than on the individual fund level, the more valuable it is.

Now, you start-off with losers, right?

Benz: Yes.

Rekenthaler: Typically the more esoteric and volatile groups--sector funds and commodity funds would be examples and international equity often--tend to have the biggest gap, and the intuition behind that is pretty simple. Because these things move the most, they're most exciting. Think about gold: When gold goes flying high, there is a lot of talk about buying gold and the gold ETF for a while was the biggest exchange-traded fund in the globe. Then when gold drops in price, people clear out. So, there is a lot of tail chasing that occurs with volatile and specialized investments, and one of the lessons that come out of investor returns is how difficult it is for people to make money in sector funds. Not only do sector funds tend to be high expense, but they're very difficult to use and people tend to constantly be tail-chasing in those.

Benz: So, that's a pretty intuitive finding. Let's discuss … you mentioned it's a narrow set of funds where investors actually do make reasonably decent timing decisions, maybe somewhat better than they do with these other very volatile fund types. Let's talk about where the investor returns look relatively better?

Rekenthaler: Well, historically bonds have done pretty well; that's fallen a little bit by the way side over the last year or so, because there is a lot of money that went into bond funds as we know since 2008, and bonds funds have not done very well.

Benz: They've done OK, but not well as equity funds?

Rekenthaler: Right. And not as well as they did in the mid-2000s.

Benz: Right.

Rekenthaler: … Through that time period with interest rates lower, and particularly not so well this year. So, the numbers are starting to turn on bond funds. They're still not too bad.

Balanced funds historically have done the best--in particular that's driven by target-date funds. Think about target-date funds; target date funds are the one type of fund where people just continue to put their money in almost regardless of what happens in the market. It's the one place where they really don't adjust their allocation.

Benz: 401(k) investors?

Rekenthaler: 401(k) investors, yes. Target-date funds are almost exclusively within a 401(k); people often don't even know they're investing in them; they've been automatically defaulted, and the money just keeps flowing in.

So, in a sense target date funds are our purest test of what happens if the investor isn't thinking about the allocation decision and the money just flows in. And those numbers look particularly good right now. Part of that is an accident of this time period, because stocks have done well over the last few years, and the money continues to flow in. There is more money over the more recent time period, which has been good for target-date funds and good for stocks.

So, again, these numbers are always dependent upon what period you look at. You have a little downturn, and the signal that you're reading can change. That's why it's important, when looking at investor returns, to look at multiple time periods, and just think about the broader lessons. And there is no denying, as I've said, the broader lesson that people in general are mistiming the purchases of their funds--that really they're getting the tactical asset allocation wrong. If they would just stick with that same strategic allocation for a long period of time, they'd be better off.

Benz: When you think about the current environment, and what we've seen from fund flows, are there any areas of concern for you, where you look at the data and flows and say, investors might be setting themselves up for some subpar returns in the years ahead? Any categories that you would point to where investors maybe are not exhibiting great timing right now?

Rekenthaler: Obviously bond funds were the big news and have been the big news, and there has been so much, and we've certainly done videos, and everyone else has: is this a bond bubble? Because there is so much money going into bond funds and.

Benz: Recently, it's been coming out, but…

Rekenthaler: Recently, but that's very small. That's a tiny, little bit of the five-year pattern, which has been money flowing into bond funds at times when interest rates were reaching, did reach, 50-year lows. So, you've got to say that's an area of concern. Again not looking at the last month--I'm not even talking about the performance of bond funds being poor recently sort of proving this thesis right, because it doesn't. It's just a month's worth of performance.

But just as a student of history of the numbers, that's a concern. That would definitely be a concern, and it would be consistent with patterns in the past where people's investor returns are worse than their total returns.

Benz: Is there a risk with emerging-markets equity as well right now? You'd mentioned to me before we got started that that's potentially another area of concern where we had seen very strong flows, but maybe investors are getting a little bit spooked now that emerging markets haven't performed well at all so far in 2013?

Rekenthaler: Yes, emerging markets are a constant problem. You want to talk about a volatile unpredictable area where people tend to invest off of headlines, and we've seen over the last six weeks or so, there have been a lot of headlines about problems in emerging markets and performance issues, and money has been flowing out--not just in mutual funds, which is subject of our discussion, but also in exchange-traded funds--almost record outflows in these exchange-traded funds.

So, I would suspect that we're going to get a strong bounce in emerging markets; I'm not saying it's going to happen …, that's for a different video to talk about market predictions, if I'd even be willing to do it. But when we do [get a bounce-back], there is going to be quite a bit less money in emerging-market funds than there was at the top there.

And maybe another area of concern would be U.S. stocks and money market funds. A lot of money flowing out of cash right now, and for the first time in a while, it's been sort of flattish. Heavy money in the U.S. stock funds, and that also would suggest that maybe that's a trade that could be reversed. Maybe the money should be flowing out of stocks right now, which have done very well, and into cash, which has been boring and paid almost nothing. But it will look good if the rest of the markets go down.

Benz: … And you want to do some shopping. John, thank you so much. Very important topic here--really, the topic, I think. We so appreciate you sharing your insights.

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